In a recent article in The Sunday Times, Michael Snyder, Senior Partner of London accounting firm Kingston Smith, commenting on a partner who found himself in an apparently intractable partnership dispute, wrote:

"We always recommend that every company has a partnership agreement or a shareholder agreement."

He went on to explain that, in the absence of an agreement, a partnership is governed by the Partnership Act 1890 (and a company by the Companies Acts and its Articles). These pieces of legislation are incapable of addressing the detailed and different issues that arise between partners and shareholders in any particular business, and this is why in any business which has more than one owner a shareholders' or partners' agreement is so important.

2. What is a Shareholders' Agreement?

A shareholders' agreement clarifies the rights and obligations of shareholders between themselves and with the company during the time they are in business together and when their business relationship comes to an end. (The company directors are also usually a party to the agreement.)

3. What does a Shareholders' Agreement cover?

The provisions of a shareholders' agreement can be divided broadly into three groups, namely the operational and management issues; the ways shares are to be issued and transferred; and the restrictions placed on shareholders/directors when they leave the company.

3.1 Operational issues
This part of the agreement should cover such things as the particular responsibilities working shareholders/directors will fulfil, the matters that need prior board or shareholder approval, limits of expenditure and borrowings on behalf of the company, director's salaries, dividend policy and possibly more detailed issues such as bank signatories, motor vehicle and entertainment expenses, etc.

3.2 Capital and share transfers
This part of the agreement is concerned with the issuing of new shares and raising of capital and the rules that will govern the transfer (i.e. sale) of shares by existing shareholders.

a) Capital raising and issuing of new shares
Where minority shareholders are concerned that their holdings could be unfairly diluted, limitations can be placed on directors to issue new capital. Alternatively, shareholders could be concerned that new shares could be issued to outsiders at less than market value. Clarification of the company's policy on raising capital and the issuing of shares can be achieved through a shareholders' agreement.

b) Share transfers
For many, this issue is the most important of all in shareholders' agreements and, indeed, for those companies without agreements share transfer issues are usually the reason for the greatest amounts of disputes.

There are two distinct areas in which share transfers are important: firstly, where any existing shareholder wishes to dispose of his or her shares and, secondly, where events or circumstances give rise to the desire by remaining shareholders to acquire the shares of a deceased or departing shareholder. The latter is usually known as "pre-emptive rights". We will look at these two issues and then consider some related topics, such as valuation and funding.

(1) Desire to sell

Where any shareholder wishes to sell his or her shares, the shareholders agreement will set out a method by which this is to be done and, very importantly, the value that will attach to the shares. This will usually entail the proposing seller being compelled to first offer the shares to the remaining shareholders at the agreed price and, in the case of the remaining shareholders not accepting the offer, being free to sell the shares on the open market.

(2) Pre-emptive rights

The rights of remaining shareholders to acquire the shares of a "departing" shareholder usually arise (or are "triggered" by) events such as the death, disability, bankruptcy, or retirement or dismissal from a company position. The agreement will state that in these circumstances the departing shareholder (or his personal representative) must offer the shares to the remaining shareholders at the agreed price.

The shareholders agreement will usually state that the remaining shareholders have the right, but not the obligation, to acquire the shares and if they decline the shares can be sold on the open market, and that directors must register any transfer.

(3) What is the agreed price?

Vital to any properly drawn up shareholders' agreement is a mechanism by which the shares that are being sold can be valued. It is largely a waste of time to have a shareholders' agreement that is silent on value, because just as many disputes arise on valuation issues as they do on whom is entitled to buy the shares.

The shareholders' agreement should, ideally, establish a method by which shares can be valued whenever the transfer arises. This can be achieved by adopting a standard valuation method (such as a price earnings ratio) to be applied to the company's profits in the year immediately preceding the proposed transfer (or alternatively to be applied to the average of the last three year's profits immediately prior to the proposed transfer). Such provisions eliminate most visits to corporate lawyers!

(4) This is fine, but how do the remaining shareholders pay?

The short answer to this is planning. The shareholders need to consider their long-term position and the circumstances that are likely to give rise to the transfers and the likely values that will attach to these shares at the relevant time. To better explain this I will give some examples.

a) In the case of a shareholder dying, the agreement could stipulate that the value of the shares will be market value (and provide a method by which this is to be established). The remaining shareholders will now be aware of their likely commitment if they are to purchase the deceased shareholder's shares and can consider how this purchase will be funded. One obvious answer would be to take out a life insurance policy on each shareholder with the other shareholders as beneficiaries (or to have the company as beneficiary and for it to buy back the shares).
b) In circumstances other than death, the agreement might stipulate a value lesser than market value (and even par value). Again shareholders can now begin to plan for these eventualities. For example a sale triggered by retirement could, perhaps, be funded by a sinking fund or other long-term investment or savings plan. Disability could be covered by insurance, whereas dismissal might mean a sale at par value only and, consequently, not require specific funding.

(5) "Drag-along" and "piggy-back" provisions
These provisions are designed, respectively, to facilitate an exit by the majority shareholders and to protect the minority shareholders in case of a sale.

"Drag-along" provisions state that if the majority shareholders wish to sell their shares to a bona fide third party purchaser for reasonable value then the minority shareholders will agree to sell their shares to the same purchaser if required to do so.

"Piggy-back" provisions state that should the majority shareholders wish to sell their shares to a purchaser, they will only do so if the purchaser is prepared to purchase the minority shareholders' shares for the same price per share.

3.3 Restrictive covenants

Shareholders' agreements should include provisions that seek to restrain former shareholders and directors of the company from harming the company's business through trading competition and/or enticing away its customers and employees.

This is a tricky area both from a legal and practical viewpoint. The law starts from the position that restraints on individuals from earning a living are unenforceable unless they can be shown to be reasonable. Restraining a former business partner form trade competition is not so difficult from the legal standpoint, although both restraints have practical difficulties when it comes to enforcement.

Restraints on trade have to be time specific and location specific to have any chance of receiving support from the courts meaning that the drafting of these clauses has to be undertaken with care.

4. Shareholders' Agreements and exit strategy planning ("ESP")

Shareholders' agreements are an important part of a larger planning process within the exit strategy planning programme. This larger process we call business Continuity Planning ("BCP"). BCP also includes such things as planning for the most tax-affective corporate structure (to take advantage of the various reliefs available against capital gains tax) and putting into place of employee agreements to ensure key personnel are locked in for the sale transition period. BCP could be viewed as the foundation blocks of ESP and should be addressed by all business regardless of when the owners intend to exit.

5. Why have a shareholders' or partnership agreement

Having read the above, the many advantages of having a shareholders' or partnership agreement will be apparent to you. As a summary, we list some of the more important disadvantages that could accrue to owners who do not have an agreement:

• In partnerships without an agreement any partner can bring the partnership to an end, which could lead to disastrous results, including the fire sale of the partnership business.
• In both partnerships and companies the departing principal (or his personal representative) could demand a price for his interests from remaining principals that is unrealistic; or the estate or heir of the departing principal could sell their interests to a third party who is hostile to, or incompatible with, the remaining principals.
• The majority shareholder could find that a potentially highly favourable disposal could be ruined because minority shareholders refuse to sell.
• The minority shareholders could find that the majority shareholder has sold his shares to a third party leaving them with a potentially unfriendly partner and an unsaleable minority interest.
• The heirs or spouse of the departing principal could effectively become the new partner or significant shareholder and insist on becoming involved in the business.
• Disputes could arise between shareholders over duties and responsibilities, who is entitled to spend what, and how much of the company's profit should be distributed as dividends. All of these could be highly disruptive and costly for the business and could even lead to a winding up, or dissolution of the partnership.
• When you come to sale negotiations, potential buyers are not happy to commit to heads of agreement and due diligence time and expense if they feel the sale could fall over because, for example, all shareholders are not bound to sell through lack of a shareholders' agreement.

6. Conclusion

We agree entirely with Michael Snyder, where there is more than one owner in a business it should have a shareholder or partnership agreement. Not only does this make sense from a general business risk management point of view, but also it is an essential component of exit strategy planning.

For departing principals, a shareholders agreement could be the basis of the perfect exit strategy. As a minimum, the departing principal must have a mechanism in place by which his estate can be paid for the transfer of his business interests and this can be achieved through a properly structured shareholders' agreement.

From the remaining principal's point of view no exit plan is complete without an agreement (and the capital) to acquire the departing principal's interests. In summary, there can be no security in long term planning unless there is certainty about the arrangements between principals.

If you would like more information on how we can prepare a shareholders' or partnership agreement for you and the cost involved, please go to the Shareholders' Agreement page.